REIT Governance: The Capital of Transparency

REITs have made strides in corporate governance over the years, in part by doing what’s asked of them by shareholders, but also by embracing the business case for improved governance.

In the eyes of executives at companies that strongly emphasize corporate governance, best practices tend to pay off.

“Having a market-leading corporate governance philosophy does help to drive shareholder value,” says Edward Nekritz, chief legal officer and general counsel at industrial REIT Prologis Inc. (NYSE:PLD). “It’s part of the core beliefs of the company, in terms of doing business the right way.”

Research backs up Nekritz’s view. REITs that had an above-average governance score traded at a premium of 2 percent to asset value, according to a 2013 report by research firm Green Street Advisors. REITs with a below-average rating traded at an average 4 percent discount to asset value.

REITs in general have improved enough to rank better in several governance categories than most industries in the S&P 500. In terms of governance risk, stock exchange-listed Equity REITs rank seventh on a list of 43 industries compiled by Institutional Shareholder Services, a monitoring service. ISS uses 80 corporate governance factors across four main areas: board structure, compensation, shareholder rights and audit. REITs had a score of 57 out of a possible 100, behind diversified utilities (100), electric utilities (98), computers and peripherals (74), diversified financial services (73), food and staples retailing (64), and insurance (58).

REITs have fared better on several fronts. About 76 percent of REIT directors are independent, compared with 73 percent of those with non-REITs, according to ISS. About 98 percent of REITs publish board guidelines, compared with 80 percent of non-REITs. Only 21 percent of REITs have staggered or classified boards, versus 42 percent of non-REITs. And only 4.4 percent of REITs have a “poison pill,” which refers to a strategy to defend against hostile takeovers, compared with 9.4 percent of all companies.

In essence, REITs such as Sunstone Hotel Investors Inc. (NYSE:SHO) have emphasized good corporate governance as a way to get a leg up on competitors. “In our space, there aren’t a lot of points of differentiation from one company to the next,” says Ken Cruse, Sunstone’s chief executive officer. “If we can demonstrate a superiority in our strategy, the way we execute our overall business—and also have a superior corporate governance—that helps set us apart.”

REITs in recent years have taken key steps in governance. On Green Street’s governance scale of 1 to 100, REITs averaged a score of 68 in 2013, compared with 52 a decade earlier. One trend bumping up that number has been the elimination of staggered terms for board members, which make it harder for investors to oust them for underperformance. About 70 percent of REITs had staggered boards in 2003. By 2013 that had dropped to 15 percent, according to Green Street.

On another positive note, independent directorships are on the rise, and these board members are increasingly making the decision of whom to bring on next. More than 75 percent of REIT board members were independent as of March, versus 71 percent four years ago, according to ISS.

Another issue involves making REITs more open to takeovers. REITs incorporated in Maryland can take advantage of the Maryland Unsolicited Takeover Act (MUTA), which allows a company to stagger its board—among other provisions—without shareholder approval. In fact, Sunstone was approached by investors last year to remove a provision in its charter that provided defensive steps against takeovers, and the company jettisoned the policy.

“It was the right thing to do,” Cruse says. “If we are doing our job, we don’t need these types of protections.”

Meanwhile, as governance improves, watchdogs and research firms are modifying what they emphasize. Green Street tinkered with its ratings last year to give more emphasis to companies headquartered in shareholder-friendly states such as Delaware. It has also given more weight to board conduct, partly based on quantitative measures such as shareholder returns and net-asset-value premiums.

GAPS TO BE FILLED

Despite the progress, REITs still have some work to do, according to industry experts. About 25 percent of REITs have an independent chairperson, compared with 33 percent of non-REITs, according to ISS. About 27 percent of REITs do not require a supermajority of shareholder votes to amend charters and bylaws, versus 40 percent of non-REITs. And only 9 percent of REITs allow shareholders to act by written consent, compared with 30 percent of non-REITs.

In a more general sense, investors would like to see more free-market forces in play should hard times hit, notes Peter Rothemund, an analyst at Green Street. In other words, it should be easier to oust management and boards at underperforming companies.

“Where REITs are coming up short are with some longstanding underperforming companies, and those companies are still around,” Rothemund says. “In a world where it’s about survival of the fittest, why haven’t the weak gotten eaten? You want to see more poor performing companies get taken over.”

A company’s governance practices aren’t so much a concern when it’s doing well, but when it stumbles, investors’ ability to have their say becomes much more important, Rothemund adds “In those cases, it’s a huge deal,” he notes.

Rothemund expressed his belief that weak governance policies from the standpoint of investors have helped some REIT boards remain shielded from investor activism. (Five or fewer individual stockholders of a REIT cannot own more than 50 percent of the shares, making seizing control more difficult to organize). Only a handful of REIT chief executives lost their jobs in the aftermath of the financial crisis, Rothemund notes, despite the significant number of companies that had to undergo expensive recapitalizations when stock prices were at their lowest.

Cruse says good governance gives investors the right to change management and the board if things go awry.

“We are all free market capitalists here,” he says. “We don’t believe in protectionism. Our viewpoint is, ‘We have stated our strategy. As long as we have executed reasonably well on our strategy, we don’t believe shareholder activism will be an issue.’”

REITs, like most publicly traded companies, are also still grappling with how executives are compensated. The matter has taken on greater importance since the implementation of the Dodd Frank Act, which required that companies hold regular say-on-pay votes starting in 2011. Compensation practices match well with non-REITs, but plans are overly reliant on growth in funds from operations, rather than metrics such as relative total returns, according to Green Street.

Another issue that has gotten much attention lately involves externally managed REITs. These arrangements relate back to the pre-1986 era when REITs were required to operate as passive investment vehicles and had to retain advisors to be managed, much like mutual funds, Linneman says. While not perfect, the internal model is better, according to Linneman. “There are still conflicts, but it’s still the most efficient way to align interest and have a company run,” he says.

“By and large, REITs have done a very nice job of cleaning up governance practices, fixing some problems that were much more rampant 10 years ago,” notes John Roe, executive director at ISS. But “there are some companies out there that continue to operate that aren’t shareholder friendly, and those are the ones that grab the press.”

The recent battle over CommonWealth REIT (NYSE: CWT) highlights a sore point among governance advocates, who recommend doing away with the structure of externally managed REITs. “It creates tremendous opaqueness,” Roe says. “Shareholders aren’t given the ability to track what companies are paying for what in terms of executive services.”

These highly publicized fights for control end up hurting all REITs in the eyes of investors, Roe adds. “There is probably a little bit of mistrust or overestimation of governance risk in the REIT industry,” he says.

HOW MUCH GOVERNANCE IS ENOUGH?

For all the good intentions of corporate governance, investors can take things too far at times and undermine the board’s role, warns James Hanks Jr., a partner at law firm Venable LLP. Directors usually know what’s best, according to Hanks, since they are familiar with the proprietary inner-workings of a company.

“Declassification, majority voting and chairman-CEO separation all have in common a fundamental distrust of the board as the intermediary between the shareholders and management,” he says. “This is despite the board having more information than any
non-management shareholders and legal duties that shareholders do not have.”

Longer-term focus of the board gets short shrift, he adds. Declassification and majority voting make it easier to replace the board every 365 days, he says, but that may not be a good thing. “These proposals are favored by short-term investors who like to see rapid turnover of companies and, therefore, discourage boards from running their companies for the long term.”

With the issue of separating chairman and chief executive, sometimes companies can convince investors that it’s best not to do so. At Prologis, Hamid Moghadam holds both titles, while the rest of its board is independent. Moghadam brings a wealth of experience from his days running AMB Property Corp., and he doesn’t chair any committees, the company argues.

“He’s the person who is best equipped to be the chairman and the CEO of the company,” Nekritz says. “We have a board comprised of 10 members, nine of whom are fiercely independent.”

STRIKING A BALANCE

When it comes to good governance, leadership and management has to come first, Cruse says. Have a clear strategic plan and stick to it. For Sunstone, that means building a high-quality portfolio, but at relatively low leverage and low risk. “Make sure your board policies are appropriate to what the company’s overall mission is,” he says. “Corporate governance should be structured in a way that is consistent with company strategy.”

Best practices also include a board with strong independence, one that has the ability to question management, address company strategy and challenge non-performing board members. “There is as much of a demand at the board level for leadership as there is at the CEO level,” says William Ferguson, co-chairman and co-CEO of Ferguson Partners, an executive search firm specializing in real estate.

“You should put as much power as you can with shareholders,” Rothemund adds. “But the board is still going to retain a lot of power. So when you say a company has good governance, the most important thing is they have a really good board, a board that you think will do the right thing.”

When it comes to corporate governance, the relationship between boards and investors boils down to putting some faith in the directors and management, contends Clifford Smith, chairman of Home Properties Inc. (NYSE: HME) and professor of finance and economics at the Simon Business School at the University of Rochester.

“We would like to look any investor in the eye and tell them we are doing our very best to manage the investments—that part of your portfolio that you have entrusted to us,” Smith says. “And that is just going to require some trust.”

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NAREIT®, the National Association of Real Estate Investment Trusts®, is the worldwide representative voice for REITs and publicly traded real estate companies with an interest in U.S. real estate and capital markets. NAREIT's members are REITs and other businesses throughout the world that own, operate, and finance income-producing real estate, as well as those firms and individuals who advise, study, and service those businesses.